Posts Tagged ‘tax shelters’

Principal’s $291 million loss struck down in Claims Court. Des Moines’ largest employer had a bad day at the U.S. Court of Federal Claims Friday when the court ruled against a $291 million loss taken on tax returns in 2000 and 2001. That was a time when many big companies took up the search for the Tax Fairy, the mythical sprite who can make millions in taxes go away with incantations and fancy wandwork.

The Principal deductions were from a “strip” transaction, where Principal Life Insurance Company purchased money-market funds, and then split them between the right to income and the, er, principal. The company retained the right to earnings for 16 to 18 years (there were multiple transactions), and sold the remaining value of the securities. It allocated all of its basis in split securities to the part it sold, generating the losses.

The IRS had a number of objections to the deduction, may of which can be found in a memo discussing similar transactions — perhaps these transactions. The Claims Court judge honed in on one: Treasury Regulations that seem to require basis to be allocated between the components of stripped securities (Reg. Sec. 1.61-6(a)):

[w]hen a part of a larger property is sold, the cost or other basis of the entire property shall be equitably apportioned among the several parts, and the gain realized or loss sustained on the part of the entire property sold is the difference between the selling price and the cost or other basis allocated to such part.

The judge didn’t care for Principal’s arguments that it properly allocated all basis to the sold piece of the securities (my emphasis):

It asserts, in effect, that the regulation has a tacit exception, that is, it does not address situations in which an income interest is carved out from a financial instrument. In that situation, PLIC claims, the proper tax treatment is governed not by the Treasury Regulations, but by “80 years of common law, which Congress and the Treasury have knowingly left in place.” PLIC cites, as evidence of this, a line of authority that it claims demonstrates not only the existence of carve-out interests, but also the fact that the normal basis allocation rules do not apply to them. It contends that this lineament well-illustrates that the basis allocation performed by PLIC here — in which all of its cost in acquiring the Perpetuals was allocated to the residual equity interest — was quite appropriate. But, as will be seen, PLIC’s invocation of these cases — and the supposed “common law” rules they embody — turns out to be something of a clupeidae roseus (or perhaps a school of them).

Clupeidae roseus must be what judges call “red herrings” when they talk to each other. In this case, the judge found the PFG arguments wanting and ruled for the IRS. It deferred its decision on whether penalties would apply pending further proceedings.

While this transaction looks like something that might have been marketed to Principal by a big law or accounting firm, the opinion doesn’t say so. The case also involved income items where IRS challenged Principal’s exclusion of $21 million from other stripped securities — a part of the case the company also lost.

The moral? I think the judge put it well: “Only in a parallel universe, where the ‘too good to be true’ rule of taxation reigns not, should the result be different.” Or as I might put it, there is no Tax Fairy.

Most industrialized countries largely exclude foreign earnings from the corporate tax base. Most industrialized countries let businesses write-off investments faster than they can in the U.S. These are not “loopholes” but broad-based ways in which these countries compete for business investment and jobs.

The “Brewster’s Millions” tax strategy. IMDB has the plot summary from this 1985 Richard Pryor vehicle:

Brewster is challenged to either take $1 million upfront or spend $30 million within 30 days to inherit $300 million. If he chooses the former, the law firm becomes executor of the estate and divides the money among charities (after taking a sizable fee). In the latter case, after 30 days, he must spend the entire $30 million within one month…

Brewster gets the idea to join the race for Mayor of New York and throws most of his money at a protest campaign urging a vote for “None of the Above”.

India’s Economic Times reports that on the Subcontinent, Brewster’s Millions is apparently a prophecy:

Made a huge profit selling your property and wondering how to avoid paying tax? Form a political party and “donate” your sale proceeds to it. And if you were worried the taxman will come knocking, just relax, it is perfectly legit. You and your party can claim 100% tax exemption too. “Many political parties are fronts for income tax fraud,” says former chief election commissioner N Gopalaswami . That explains the burgeoning political party registrations. There are about 1,600 political parties in India, but only 100-150 actually contest elections.

The Supreme Court wrapped a bow around the IRS victories in the turn-of-the-century tax shelter wars by unanimously ruling that the 40% “gross valuation misstatement” penalty applied to a tax understatement caused by the “COBRA” tax shelter.

COBRA relied on contributing long and short currency options to a partnership, but claiming basis for the long position, and ignoring the liability caused by the short position. The shelter was cooked up in Paul Daugerdas’ tax shelter lab at now-defunct Jenkens & Gilchrist and marketed by Ernst & Young. The shelter was designed to generate $43.7 million in tax losses for a cash investment of $3.2 million.

COBRA, like so many other shelters of the era, was ruled a sham and the losses disallowed, but the Fifth Circuit Court of Appeals ruled that the 40% penalty did not apply. Other circuits ruled that it did, so the Supreme Court took the case to settle the issue.

In the alternative, Woods argues that any underpayment of tax in this case would be “attributable,” not to the misstatements of outside basis, but rather to the determination that the partnerships were shams — which he describes as an “independent legal ground.” That is the rationale that the Fifth and Ninth Circuits have adopted for refusing to apply the valuation-misstatement penalty in cases like this, although both courts have voiced doubts about it.

We reject the argument’s premise: The economic substance determination and the basis misstatement are not “independent” of one another. This is not a case where a valuation misstatement is a mere side effect of a sham transaction. Rather, the overstatement of outside basis was the linchpin of the COBRA tax shelter and the mechanism by which Woods and McCombs sought to reduce their taxable income. As Judge Prado observed, in this type of tax shelter, “the basis misstatement and the transaction’s lack of economic substance are inextricably inter twined,” so “attributing the tax underpayment only to the artificiality of the transaction and not to the basis over valuation is making a false distinction.” In short, the partners underpaid their taxes because they overstated their outside basis, and they overstated their outside basis because the partnerships were shams. We therefore have no difficulty concluding that any underpayment resulting from the COBRA tax shelter is attributable to the partners’ misrepresentation of outside basis (a valuation misstatement).

I see the basis-shifting shelters of the 1990s as elaborate incantations designed to to get the Tax Fairy to magically wish away tax liabilities. Like any good witch doctor, the shelter designers relied on lots of elaborate hand-waving and dark magic to do their work, and they collected a lot of cash for their work. But there is no Tax Fairy. Justice Scalia has let Tax Fairy believers know that pursuing her is not just futile, but potentially very expensive.

Blue Book Blues. One digression by Justice Scalia in Woods is worth a little extra attention. From the opinion (citations omitted, my emphasis):

Woods contends, however, that a document known as the “Blue Book” compels a different result…Blue Books are prepared by the staff of the Joint Committee on Taxation as commentaries on recently passed tax laws. They are “written after passage of the legislation and therefore d[o] not inform the decisions of the members of Congress who vot[e] in favor of the [law].” While we have relied on similar documents in the past, …our more recent precedents disapprove of that practice. Of course the Blue Book, like a law review article, may be relevant to the extent it is persuasive.

Back in the early national firm days of my career, one of my bosses was a former national firm lobbyist who was exiled to The Field when a merger with another firm left room in Washington for only one lobbyist in the combined firm. I remember him telling clients that he could get around unpleasantness in the tax code by arranging for helpful language in the Blue Book. From what Justice Scalia says, he would have done as well by writing a law review article.

While the IRS has existing practices to address ACA-related fraud, the agency’s approach is not part of an established fraud mitigation strategy for ACA systems, the report says. The IRS has two systems under development to lessen ACA tax refund fraud risk, but until those systems are completed and tested, “TIGTA remains concerned that the IRS’s existing fraud detection system may not be capable of identifying ACA refund fraud or schemes prior to the issuance of tax return refunds,” it says.

IRS Chief Technology Officer Terence Milholland said in a response included in the report that fraudprevention plans will be put in place as ACA systems are released.

It’s clear that for 2013 and going forward, couples in same-sex marriage will only need to apply “married person” rules to IRAs (and to everything else relating to their taxes).

What’s less clear is what happens with differences between federal and state basis for prior years.

Robert D. Flach, A YEAR END TIP FOR MUTUAL FUND INVESTMENTS. “If you want to purchase shares in a mutual fund during the fourth quarter of the year, wait until after the capital gain dividend has been issued, and the NAV has dropped, before purchasing the shares.”

Missouri Rep Paul Curtman (R) wants to index his state’s income tax brackets to inflation. Of all the tax ideas presented this year, this is among the best. Missouri imposes its top rate of 6 percent on all incomes over $9,000. Nine grand was a lot of money in 1931 – and the top tax rate was aimed at the very wealthiest Missourians. But that threshold hasn’t changed since Herbert Hoover was president.

Tax Shelter STARS dims in Claims Court. The high-priced marketed tax shelter craze that started in the late 1990s by the big national accounting firms and some law firms has produced terrible results in litigation. The latest failure is the KPMG/Sidley Austin tax shleter “STARS,” which was shot down in the Court of Federal Claims last week.

The shelter was designed to generate foreign tax credits against BB&T Corporation’s U.S. taxes. While the shelter was put together by some of the biggest names in the tax profession, the judge was unimpressed:

Applying these principles here, the STARS transaction must be seen for what it really is. By creating a trust arrangement with nothing but circular cash flows, and momentarily placing funds in the hands of a U.K. trustee before it is returned, Barclays and BB&T artificially caused a U.K. tax on U.S.-sourced revenue. There was no substantive economic activity occurring in the U.K. to warrant a U.K. tax. Yet, by subjecting the Trust funds to a U.K. tax, Barclays and BB&T were able to share the benefits of foreign tax credits, which resulted in a 51 percent rebate of a Bx payment to BB&T. The surprisingly low interest rate to BB&T on the $1.5 billion Loan, 300 basis points below LIBOR, was made possible solely because of the fruits of the Trust arrangement. In reality, the U.S. Treasury is funding the monetary benefits realized by BB&T, Barclays, and the U.K. Treasury. No aspect of the STARS transaction has any economic reality.

When taxpayers got involved in tax shelters set up by big-name firms, they often did so believing that reliance on well-known national firms will protect them from penalties. Not here:

KPMG’s overarching advice was that BB&T should engage in an economically meaningless transaction to achieve foreign tax credits for taxes BB&T had not in substance paid. Thus, because KPMG’s advice was based on unreasonable and unsupported assumptions, the Court finds KPMG’s advice unreasonable.

Based on KPMG’s recommendation, BB&T also selected the law firm of Sidley Austin, and in particular, Raymond J. Ruble, to provide tax advice and a formal opinion on STARS… Because Sidley Austin’s tax opinion was premised on the unreasonable and unsupported assumption that technical compliance with U.S. tax law would allow the IRS to give its imprimatur to an economically meaningless transaction, the Court finds Sidley Austin’s advice unreasonable.

So the judge undid $660 million in claimed tax savings and added $112 million in penalties to the bill.

The Moral? Some of the brightest minds in the tax business thought they had finally found the Tax Fairy, the magical sprite that can make your taxes go away with fancy tax footwork. They sold their discovery to folks just as eager to believe in the Tax Fairy as they were. But there is no Tax Fairy.

Iowa: an alcohol-dependent nicotine fiend with a gambling problem. From the Sioux City Journal:

In fiscal 2012, Iowa reaped $710.6 million from so-called “sin taxes.” Although that was 4.8 percent of the state’s total revenues of $14.65 billion, it was far less than the $3.7 billion in individual income taxes and $2.1 billion in sales taxes Iowans paid in fiscal 2011.

Still, it greatly exceeds the net take of Iowa’s complex, high rate and futile corporation income tax, which netted $430.4 million of the state’s $7.42 billion in tax revenues in fiscal 2012.

Branch profits tax is computed on the corporation’s taxable income. The branch profits tax does not care about your net operating loss.

This means that you can have years where the corporation pays no income tax (because it has a net operating loss from the prior year that eliminates the taxable profit generated in the current year). But the corporation will pay the branch profits tax.

If you deal with offshore corporations with U.S. activity, you should read this.

Many practitioners are gun-shy when it comes to voicing their opinions on tax policy. They have clients, after all, who might disagree with them. Joe Kristan of Roth CPA, a leading tax and accounting firm in Iowa, is an exception. Kristan, writing for the firm’s blog, routinely speaks truth to power. We here at Tax Analysts appreciate that.

That’s the nicest way anybody has ever said that I don’t know when to shut up.

Durham talks about the tax-incentive imperative, which only the gods of crony capitalism would recognize. But then one would expect a government official who spends her time doling out government welfare to corporations to defend the idea of doling out welfare to corporations. Citing the state’s blue ribbon commission, Kristan pointed out that there is little evidence that tax incentives work.

Kristan has criticized State Sen. Joe Bolkcom (D) for arguing for targeted tax incentives. Targeted incentives violate every notion of sound tax policy and, as Kristan wisely points out, assume the state can wisely allocate investment capital. We need more people who understand how everything works to weigh in on tax policy.

I would be surprised if you could fill a coffee table at the Capitol cafeteria with legislators who could explain the opportunity costs of targeted tax credits.

A federal judge Friday sentenced a key player in the once-lucrative Jenkens & Gilchrist tax shelter practice to eight years in prison. From the AP:

U.S. District Judge William H. Pauley III sentenced 52-year-old Donna Guerin, of Scottsdale, Ariz., after she pleaded guilty to conspiracy to defraud the United States and tax evasion. He ordered her to pay $190 million in restitution besides the $1.6 million she agreed to forfeit when she pleaded guilty in September.

Guerin, a former partner at Jenkens & Gilchrist, a Texas-based law firm with offices throughout the United States, had admitted that she helped market tax shelters from 1994 through 2004 to some of the world’s richest investors, including the late sports entrepreneur Lamar Hunt, trust fund recipients, investors, a grandson of the late industrialist Armand Hammer and one of the earliest investors in Microsoft Corp.

The biggest prosecution target at Jenkens, Paul Daugerdas, faces his second trial on the charges in September. His 2011 trial was voided because of juror misconduct.

Dare we attempt to guess what the income tax might look like in another 100 years?

Personally I think it will still exist, but it will have company. The big question for policymakers is whether it should operate as a “mass” tax — as it strives to do today — or whether it will function as a “class” tax that applies only to the upper income strata. Given that roughly 47% of American households currently don’t pay the income tax (distinguished from payroll taxes, which almost everyone pays), one could argue it is already starting to resemble a class tax. Perhaps the future is already here.

I can state with some confidence that if there is an income tax in 2113, I won’t be preparing returns.

There are many ways to get in trouble with tax law. As I have said in the past, if you want to get indicted it’s a bit harder. It helps to be a celebrity, have a very large tax debt, not report large amounts of funds in foreign financial accounts, or abscond with trust fund taxes. I need to add another item to that list: File liens against IRS employees who are investigating you.

The City of Des Moines will finally do the right thing, having exhausted all venues to do otherwise. The Supreme Court yesterday ruled that the city must repay $40 million of an illegally-imposed franchise fee on utility bills. The Des Moines Register reports:

The high court’s ruling centers on franchise fees that are added to customers’ gas and electricity bills. A lower court ruled that the city charged excessive fees for a period of years, in essence an illegal tax. The high court declined to review the lower court’s order requiring the city to repay roughly $40 million to residents who paid the illegal tax.

Mayor Cownie predicts disaster and famine:

City lawyers have fought the case for years by arguing, in part, that any refunds would lead inevitably to higher property taxes — in essence taking money out of one pocket of city residents to place cash in another.

Cownie said the city would pursue options fairest to citizens while balancing the long-term realities of a beleaguered city budget. Any franchise fee repayment from the city would likely come from a mixture of property tax increases and cuts to city services, he said.

“We’re not just cutting away fat. We’re cutting away muscle and bone and tendons,” he said.

It’s useful to imagine how much sympathy the city would offer a taxpayer who had illegally collected money from the city. “I’m not just cutting away fat. I’m cutting away essential services for myself and my family, like my house and my car.” Of course, the city has compounded its own problems by litigating all the way to the U.S. Supreme Court, piling up legal fees and interest on top of the refunds.

The city now has to pay up, though the Register story makes it look like the city isn’t exactly racing to cut the refund checks.

The Moral? Next time, don’t collect an illegal tax, and if you do, repay it.

Supreme Court declines to review West Des Moines S corporation compensation case. In addition to denying Des Moines’ franchise tax appeal, the Supreme Court yesterday denied a hearing in an important case involving the so-called “John Edwards Shelter,” named after the former vice-presidential nominee and model husband who ran his law practice in an S corporation.

A U.S. district court held that an area CPA who reported $24,000 of wage income and around $200,000 of K-1 income from his S corporation had to report as compensation around $90,000 of the income; the Eighth Circuit upheld the ruling in February (David E. Watson, P.C. v. U.S). The tax law imposes payroll taxes on compensation, but not S corporation K-1 income, so the taxpayer must pay payroll taxes on the additional compensation. The denial is reported on page 50 here.

A Cerritos CPA and Los Angeles attorney were arrested today on felony charges of conspiracy and tax evasion, the Franchise Tax Board announced.

Victor George Kawana, 53, and Blair Stover, 51, each own one-third of Kruse Mennillo, LLP. According to FTB special agents, Kawana and Stover allegedly promoted an abusive tax avoidance transaction (ATAT) to more than 100 clients during the years 2002-2005. The fraudulent activity cost the state more than $7.6 million in tax liability.

They each face three felony counts of aiding in the preparation of false state income tax returns and one felony count of conspiracy. Each tax count carries a maximum sentence of three years in state prison.

The charges appear to arise from the same sorts of shelters Mr. Stover was enjoined from promoting:

They instructed their clients to utilize an ATAT involving the creation of Nevada corporations and Roth IRA or Employee Stock Option Plans (ESOP) as the sole shareholders. The ATAT was formed with a series of related transactions with no valid business purpose other than tax evasion.

Kawana and Stover were recently arrested and both pleaded not guilty at their arraignments.

Mr. Stover got his start at national firm Coopers and Lybrand in St. Louis, later moving to their Kansas City office. He joined the Grant Thornton office there before going to Kruse Menillo, LLP.

While a number of the tax shelters involved did poorly in court, that doesn’t make it a crime to promote them; the defendants are innocent until proven guilty. Whatever the outcome of the trial, we can safely assume that the shelters relied on taxpayers’ eternal pursuit of the tax fairy, that mythical creature who can magically make income taxes go away without pain and without risk. There is no tax fairy.

Thanks to an alert reader for the tip.

Martin Sullivan, Romney Advisor Advocates Tax Hikes (Tax.com): “He proposes putting a cap on everyone’s tax benefits from deductions and credits equal to some percentage (perhaps 2 or 3 percent) of adjusted gross income and using the revenue gained for both rate cuts and deficit reduction”

If Congressional gridlock sends the U.S. government tumbling over the fiscal cliff later this year, Americans could face an average tax hike of almost $3,500 in 2013. Nearly 9 of every 10 households would pay higher taxes. Every income group would see their taxes rise by at least 3.5 percent, but high-income households would suffer the biggest hit by far, according to a new Tax Policy Center analysis.

Jenkens tax shelter maven Daugerdas wins new trialbecause Juror #1 lied about her background. Paul Daugerdas, the biggest target of the Justice’s Department’s criminal offensive against the tax shelter industry of the early 200os, and two other co-defendants will get a new trial. If I were on the jury and found my time had been wasted by Juror #1, I’d be irate. The conviction of another defendant stood because the judge believed that defendant’s lawyers knew that the juror wasn’t being honest. Background here. The TaxProf has more. So does Jack Townsend

Iowa is #16 in per-capita income tax collections (Tax Policy Blog). New York is #1.

Robert D. Flach has some “Unique Tax Deductions” today. Guess what profession can deduct its body-oil expenses?

“Save now, pay later. 2-for-1 tax savings!”
Ah, for the good old days of real estate tax shelters. Until the 1986 enactment of the “passive loss rules” killed them off, they sold like cheap beer. Like too much cheap beer, they led to hangovers. Peter Reilly explains how a shelter built around Pittsburgh’s U.S. Steel Tower, 600 Grant Street LP, gave one investor to a Pennsylvania-sized tax headache:

Mr. Marshall put about $150,000 into the partnership and received a little more than $6,000 in distributions over the roughly 20 years that he owned an interest in the partnership. The real estate was sold at a sheriff

There is no tax fairy, despite of the best efforts of big law and accounting firms a decade ago. The founder of Buy.com learned the sad truth the hard way this week when the Tax Court ruled against his “OPIS” tax shelter, marketed by KPMG. The court ruled that the shelter failed to protect Scott Blum from $25.7 million in federal taxes for 1998, 1999 and 2002. It also upheld a $10.2 million penalty assessment. The TaxProf has more.
Cite: Blum, T.C. Memo. 2012-16

Presidio Advisors, LLC, a boutique firm at the center of the tax shelter industry of the late 1990s, got another spot on its record last week in the Court of Federal Claims. This time, the losers weren’t outside tax shelter investors, but Presidio’s founders.
Presidio put together a basis-shifting shelter that involved transferring assets to “qualified subchapter S subsidiary,” or QSUB. If an S corporation owns 100% of the stock of another corporation, the subsidiary’s activities are included on the S corporation return if the subsidiary makes a “QSUB” election.
Presidio set up a shelter deal where it set up a corporation, PCC, to buy equiment from a foreign corporation for consideration for $11.7 million, including an obligation to close a $12 million short sale on treasury securities. The equipment had a built-in loss of around $11.4 million, based on this value. The organizers contributed the PCC stock to an S corporation called Prevad, owned largely by lead figures in Presidio. PCC was intended to be a QSUB of Prevad.
PCC then contributed the property to Presido Advisors, LLC, which then sold the property for a big loss, which passed through the LLC K-1 to the QSUB and thence to the Prevad S corporation return.
Except for one little problem. The court explains:

In this case, petitioners contend that PCC was a QSub of Prevad, entitling Prevad to treat PCC’s assets as its own, as of the effective date of the election. They further assert that Prevad assumed PCC’s $11,881,813 basis in the latter’s equipment before that equipment was contributed to Presidio on November 8, 1998. The latter must be true if Presidio has any hope to deduct the $10,644,471 loss it claims on Presidio’s subsequent sale of the equipment. In its motion for partial summary judgment, however, respondent argues that Prevad’s election to treat PCC as a QSub was not effective as of November 8, 1998, such that PCC’s allegedly stepped-up basis in its equipment did not carry over to Presidio. It would appear that respondent is right.

Did somebody fail to file a QSUB election? No; it looks more like the shelter organizers were careless in throwing their entities around:

Rather, petitioners admit that Prevad did not become the sole shareholder of PCC until November 6, 1998. Petitioners, moreover, further admit that Prevad did not retain its ownership of PCC, but rather, on the same day, transferred its shares in PCC to Presidio. Accordingly, PCC was not held by a Subchapter S corporation for the entire retroactive period in question and thus failed to qualify as a QSub.

It’s not clear the shelter would have worked if the equipment had been a QSUB on November 8, but it clearly fails once the court decides that it wasn’t. Without an effective QSUB election, the loss is locked in a C corporation with no income of its own.The Moral? Paperwork matters. If you are basing a big transaction on effective dates of incorporations and tax elections, and you are cutting it close, make very sure that your paperwork has all of the right dates.
Cite: Presidio Advisors LLC, Ct of Federal Claims No. 05-411.

One of the products marketed by a national accounting firm in the turn-of-the-century tax shelter frenzy turns out to have cost a taxpayer a lot more than back taxes. The shelter turns out to have blown the taxpayer’s S corporation election.
KPMG marketed the “SC2″ tax shelter to enable S corporation owners to have their cake and eat it too. The shelter had S corporation shareholders donate shares to a tax-exempt entity. Where the income was interest and dividends, it didn’t subject to “unrelated business income tax” and was therefore tax free. A federal judge explains what happens next:

During this period, the S corporation’s income accumulates in the corporation; distributions are minimized or avoided. After the pre-determined period of time has elapsed, the charity sells the “donated” shares back to the original shareholders. Tax has been avoided for the period of time that the shares were “parked” in the charity, and the accumulated income of the S corporation may be distributed to the original shareholders either tax-free or at the favorable long-term capital gains rate.

But what if the charity doesn’t want to sell?

The original shareholders retain control over the S corporation by donating only non-voting stock while retaining all shares of voting stock. Moreover, to protect against the possibility that the donee charity might refuse to sell its majority stock back to the original shareholders after the agreed-upon length of time, warrants are issued to the original shareholders prior to the “donation.” The warrants enable the original shareholders to purchase a large number of new shares in the corporation; if exercised, the warrants would dilute the stock held by the charity to such an extent that the original shareholders would end up owning approximately ninety percent of the outstanding shares. Thus the warrants allow the original shareholders to retain their equity interest in the corporation even though the charity nominally is the majority shareholder.

So if the charity doesn’t want to sell, the taxpayer can dilute them to insignificance.
The problem?

There are no tax miracles.
Sure, lots of folks say there are, if you just hire them, or buy their book. There are always clients for those who promise a painless end to tax woes, and there’s always an audience that wants to hear that their old tax pros are just incompetents or wimps who are afraid to take on The Man.
A case decided by the Eighth Circuit Court of Appeals holds a lesson for these folks. The Eighth Circuit upheld an injunction against a host of tax plans promoted by former Coopers & Lybrand and Grant Thornton attorney A. Blair Stover. These included:
– A setup using a “parallel” C corporation with a November year end to suck all of the income out of an S corporation as “management fees” in December, providing an 11-month deferral of the tax on the income.
– A similar deal where the substance-free management company was owned by an ESOP, thus sheltering the income until it was withdrawn by the owner.
– Still another deal where the “management” C corporation was owned by a Roth IRA.
While these may have seemed attractive at the time, they worked out badly for the clients. From the Appeals Court opinion:

The IRS conducted a lengthy and costly investigation into Stover’s schemes. The district court found that agent Rhonda Kimball spent over three thousand hours (more than one year’s normal work) unraveling transactions for just two of Stover’s clients. It also found that even the most conservative estimate of the tax loss to the government caused by Stover’s schemes was $100 million, and potentially as high as $800 million. Agent Janice Mallon testified that a “reasonable estimation” of the government’s tax loss was $300 million. Apart from those costs, most of Stover’s clients had to pay other professionals to “undo” the structures Stover promoted, organized, and sold. Many had to pay penalties to the government.

A tax plan hatched by a Kansas City-area tax advisor met disaster in Tax Court this week. The plan was the braincraft of A. Blair Stover, a former Grant Thornton tax practitioner. Mr. Stover has since come under unpleasant government scrutiny for overly-imaginative tax planning.
If everything worked out, it would have moved about $1.3 million from a traditional IRA, where it would have been taxable when withdrawn, to a permanently tax-free Roth IRA.
The plan was simple, yet absurd. When the smoke cleared, it worked like this: the taxpayer set up a new Roth IRA with a $2,000 contribution. He then had the Roth IRA and his existing traditional IRA set up new corporations. The Roth IRA-owned corporation got the $2,000 Roth contribution, while the Traditional IRA corporation got the $1.3 million in Traditional IRA assets. The Traditional IRA corporation then merged into the Roth IRA corporation. Suddenly the Roth IRA magically owned $1.3 million in assets, rather than $2,000. What could go wrong?
Mr. Paschall, the taxpayer, paid accounting firm Grant Thornton $120,000 to set up this transaction. GT’s Mr. Stover took care of the paperwork details. The taxpayer probably took comfort in this from the GT engagement letter:

The engagement letter contemplated a fee of $120,000 and contained a clause providing that Grant Thornton would represent and defend Mr. Paschall or any related entity at no additional cost in case of audit by the Internal Revenue Service (IRS). The engagement letter also contained an indemnity clause providing that Grant Thornton would reimburse and indemnify the Paschalls and any related entity for any civil negligence or fraud penalty assessed against them by Federal or State authorities.

Unfortunately for the taxpayer, Mr. Stover’s tax planning came under IRS scrutiny. The Tax Court explains:

In either 2003 or 2004 Mr. Paschall received a letter stating that Grant Thornton was turning over the names of people who had engaged in Roth restructures to the IRS. Mr. Stover at this time advised Mr. Paschall that the Roth restructure was legal but that he “might want to disclose on [his] income tax returns the structure”. Mr. Paschall thereafter attached to Telesis’ and his personal tax returns Forms 8886, Reportable Transaction Disclosure Statement.

When the taxpayer set up his Roth IRA, the annual limit for contribuitons was $2,000. The tax law applies a 6% annual penalty for excess contributions until the excess contribution and earnings are eliminated. The IRS said the $1.3 million moved into the Roth IRA was an excess contribution; over five years, that added up to $425,513 in taxes, plus another $105,000 or so in penalties.
The taxpayer naturally objected. The taxpayer first argued that the statute of limitations had expired on the tax, because he had filed timely 1040s more than three years before the assessment. The court ruled that the three-year statute never started running because he had never filed Form 5329, the form for reporting excess IRA contributions.
As for the substance of the transaction, the Tax Court said:

The substance of what happened in the instant case is that approximately $1.3 million began the year in Mr. Paschall’s traditional IRA and was transferred to his Roth IRA by the end of the year with no taxes being paid. Mr. Paschall did not attempt to provide a nontax business, financial, or investment purpose for what he did, and this Court cannot ascertain one. Instead, Mr. Paschall, incited by and at the urging of Mr. Stover, used corporate formations, transfers, and mergers in an attempt to avoid taxes and disguise excess contributions to his Roth IRA.

In upholding penalties against the taxpayer, Judge Wherry said the taxpayer should have known better:

Mr. Paschall should have realized that the deal was too good to be true. See LaVerne v. Commissioner, supra at 652-653. Mr. Paschall is a highly educated and successful businessman. He explained to this Court that because he grew up in the Depression, he was conservative with his investments and worried “about having enough money” to last through retirement. Yet he paid $120,000 for a transaction that he “did not fully understand”.
Mr. Paschall had doubts, repeatedly asking whether the Roth restructure was legal. Despite these doubts, he never asked for an opinion letter or sought the advice of an independent adviser, including Mr. Jaeger, who was preparing his tax returns at the time he met Mr. Stover. This was even after he received a letter warning him that there might be problems with the Roth restructure and that his name was being turned over to the IRS.

The Wall Street Journal Law Blog has an update on the criminal trial of Paul Daugerdas. Mr. Daugerdas is probably the most prominent figure targeted by federal prosecutors in the aftermath of the mass-marketing of tax shelters in the late 1990s and early part of this century. He is said to have made $95 million in fees as the brains behind now-discredited basis-shifting shelters with names like CARDS and Son of Boss.
Jack Townsend has a technical analysis of the case up today.

I have just today read the transcript for the instruction conference on 5/5/11 in the Daugerdas criminal case. Daugerdas involved the same basic pattern as the Larson and Coplan cases (previously discussed here and here). That pattern is the prosecution of the enablers but not the taxpayers (or taxpayer advisors), with even a concession that for purposes of the submission to the jury the taxpayers are not guilty of the crime of evasion. In these cases, the prosecutors trot out several redundant or just not applicable theories of liability as if they were different than criminal liability for the underlying criminal offense of tax evasion. They are not.

Two prominent figures in the high-end marketed tax shelters of the 1990s and early part of the last decade were sentenced for tax crimes last week. From the Department of Justice Press Release:

Quellos founder and former CEO JEFFREY I. GREENSTEIN, 48, of Mercer Island, Washington, and former Quellos tax attorney CHARLES H. WILK, 52, of Seattle, pleaded guilty in September 2010. Today both men paid the IRS $7 Million in penalties related to their personal gain realized from the design, promotion and implementation of the fraudulent tax shelter, which they called POINT. The estimated tax loss from the scheme is $240 million. Those losses have since been repaid by the taxpayers.

Most of the big tax shelters at least involved real transactions, even if they were rigged to create tax losses without economic substance. Not so here, according to the press release:

Greenstein and Wilk did not tell clients, or the attorneys who evaluated the proposals, that the POINT transaction was predicated on a sham. They knew but did not disclose that there was no offshore investment fund, and that no shares of stock were actually purchased and possessed by any offshore investment fund. They knew that the purported offshore investment fund was merely a shell entity with nominee administrators and no assets or employees.

The Tax Court yesterday ruled that a taxpayer who invested in a bad tax shelter couldn’t rely on the opinion of his lawyer — who got a fee for selling the deal — to avoid penalties. Judge Holmes explains how the advice of attorney Garza and accountants Turner and Stone fell short (my emphasis):

We find that both these advisers not only participated in structuring the transaction, but arranged the entire deal. Garza set up the LLCs, provided a copy of the opinion letter, and coordinated the deal from start to finish. And both Garza and Turner & Stone profited from selling the transaction to numerous clients. Garza charged a flat fee for implementing it and wouldn’t have been compensated at all if Palmlund decided not to go through with it. He wasn’t being paid to evaluate the deal or tweak a real business deal to increase its tax advantages; he was being paid to make it happen. And Turner & Stone charged $8,000 for preparing Palmlund’s tax returns — $6,500 more than usual. The extra fees were not attributable to an extraordinarily complex return — Palmlund’s returns were always complex due to his various business interests — but, we find, were the firm’s cut for helping to make the deal happen. Because Palmlund’s advisers structured the transaction and profited from its implementation, they are promoters. Palmlund therefore could not rely on their advice in good faith.

The moral? If the drug dealer tells you it’s legal, you’ll still get in trouble for smoking dope, and if the promoter tells you the tax shelter is legit, that doesn’t help if the judge finds otherwise.
Cite: 106 Ltd., 136 T.C. No. 3

Deutche Bank has settled potential charges arising out of its role in the mass marketed tax shelters of the late 1990s and early part of the last decade. The German Bank enabled many of the shelters that brought national accounting and law firms to grief. Jack Townsend explains the deal:

1. DB admits criminal wrongdoing.]
2. A payment of $553,633,153, representing DB’s total fees from its participation in tax shelter activity, the tax and interest the IRS was unable to collect from the taxpayers entering those shelters, and a civil penalty of over $149 million.
3. DB provided a detailed Statement of facts admitting its tax shelter shenanigans.
4. DB must implement and maintain an effective compliance and ethics program. Incident to this commitment, DB must install a government-appointed independent expert to oversee the program. The independent expert is Bart Schwartz of Guidepost Solutions.
5. The shelters involved, with the ubiquitous, sometimes tongue in cheek, acronyms included:
a. BLIPS (involving KPMG)
b. FLIP/OPIS (involving KPMG)
c. Short Option Strategies (SOS) (involving Jenkens & Gilchrist (Daugerdas et al), KPMG,. E&Y and others.
d. PICO and POPS (involving “various accounting firms and other entities)

In hindsight, it’s amazing that people thought this stuff would work, but it was hard for those of us who weren’t selling “product” to convince clients that the big boys were selling snake oil.

A federal appeals court upheld convictions of two of the defendants convicted in the KPMG tax shelter trial after charges against most of the defendants were thrown out. Jack Townsend, a defense attorney in criminal tax cases, thinks the circuit court shouldn’t have been so glib.
More from the TaxProf.

When big hog farm operator Murphy Farms was acquired by even-bigger Smithfield Foods in 1999, the Murphy family faced a big capital gain tax. Like many taxpayers at the time, the family tried to avoid the tax through a generic tax shelter offered by one of the national accounting firms. They ended up using a “COBRA” transaction sold by Ernst & Young — a version of the “Son-of-Boss” shelter. The Court of Federal Claims explains (footnotes omitted):

COBRA involved foreign currency options. The strategy called for at least two individuals to each simultaneously sell a short option and purchase a long option at a different strike price. The individuals then transfer the option contracts along with cash to a newly formed general partnership, receiving in return an interest in the partnership. So long as the options expired out of the money, the partnership recognizes a loss. The individuals then transfer the entire partnership interest to a newly formed S corporation, which causes the partnership to be terminated. The partnership liquidates and distributes its investments to the S corporation. The S corporation sells its assets to an unrelated third party, generating a loss for tax purposes.

Because there are offsetting long and short positions, the taxpayer is protected against a real economic loss. The IRS issued a notice attacking these basis-shifting tax shelters, and E&Y stopped marketing the shelters. The family chose to go ahead with the shelter anyway, and the accountants agreed to set it up after the Murphys singed an agreement to hold them harmless from any penalties. According to the court, E&Y earned $2.5 million for their efforts to shelter a $100 million gain.Flickr image courtesy Laertes under Creative Commons license.
The IRS disallowed the Murphy losses, and, perhaps as a result of universal failure of taxpayers to prevail on these deals in court, the Murphy family conceded to the IRS adjustments. They weren’t too crazy about the 40% gross valuation misstatement penalty. They appealed it to the Federal Claims Court, citing reliance on their internal tax guru and Ernst and Young.
Not surprisingly, the court didn’t allow the family to rely on their in-house advisor for “independent” advice. As to Ernst and Young:

In the circumstances presented here, reliance on E&Y’s advice was not reasonable. As the Federal Circuit stated in Stobie Creek: “Reliance is not reasonable, for example, if the adviser has an inherent conflict of interest about which the taxpayer knew or should have known.” 608 F.3d at 1381. The Murphys could not reasonably have expected to receive independent advice from the same firm that was selling them COBRA. Because E&Y had a financial interest in having the Murphys participate in COBRA, the firm had an inherent conflict of interest in advising on the legitimacy of that transaction.
That conflict of interest was exacerbated by the fee structure. The Murphys have conceded that from the beginning they understood that E&Y’s fee would be a percentage of their desired tax loss.

Assuming the $100 million Murphy capital gain was taxed at 20%, the penalty is $8 million, on top of the $20 million in tax and the $2.5 million shelter fee.The Moral? If you want to rely on ouside advice to avoid potential penalties, make sure the advisor isn’t on your payroll and doesn’t get paid based on the amount of your tax savings.
Cite: Murfam Farms LLC, Ct. Claims Nos. 06-245T, 06-246T, 06-247T